Apples to Apples? Mutual Funds vs. ETFs

Let’s start with the basics. What is a mutual fund and how does it work?

A mutual fund is a pool of money received from investors that is managed by an investment company. Mutual funds issue and redeem shares at their net asset value (NAV), the price at which you can buy or sell a share that is calculated after the market closes for the day. So when you put an order in to buy or sell a mutual fund, it’s not executed until after the market is closed. This is why you can’t specify the price at which you’d like to buy a mutual fund, as the price is unknown until the market closes and the NAV is calculated. Instead, you have to specify the amount you want to invest in a mutual fund, for example $2500 worth of ABCDE mutual fund, and then the quantity of shares you end up with is determined by the NAV.

Moving on to ETFs – what is an ETF and how does it work?

ETF stands for exchange-traded fund (literally, traded on the stock exchange) and is a collection of assets that tracks an index. Examples are ETFs that track the S&P 500 or the Russell 2000, a sector like energy or biotech, a country or region like Vietnam or the Caribbean basin, a commodity like gold or coffee, or a currency, among others. ETFs offer more trading flexibility than mutual funds as they trade continuously when the market is open and can be sold short or bought on margin. As such, ETFs are traded at their current market price instead of their NAV, like stocks.

Investment returns of mutual funds are granted “pass-through status” under U.S. tax code, meaning that taxes are paid by the investor, not the mutual fund. When capital gains and dividends earned in the mutual fund are paid out to investors, typically once or twice a year, investors are liable for taxes on this income. This can lead to a few undesirable scenarios. One, the investor who just bought shares and receives a distribution is liable for taxes resulting from transactions that occurred before they bought the shares. This is a common concern late in the year when distributions are often made. Two, if the mutual fund loses value, particularly below the price at which it was originally bought, the investor is still liable for taxes on it. In general, owning mutual funds reduces the investor’s ability to manage their taxes.

By contrast, ETFs are much more tax-efficient as they are structured to shield investors from capital gains taxes. Redemptions of ETFs do not trigger a stock sale within the fund as they do in mutual funds, so no capital gains or any resulting taxes are passed on to investors. Of course, the investor is still liable for taxes with ETFs if they realize capital gains upon selling them or receive dividends.

Mutual funds are relatively expensive to own. Since they are actively managed by an investment company, the company incurs an array of fees that cuts into returns. These fees can be divided into two main categories. The first category is the operating expenses of the fund, which includes the cost of paying the fund managers, administrative fees, and sales and marketing fees (aka 12b-1 fees). These expenses are expressed as an expense ratio, which ranges from 0.2-2.0%, and the average mutual fund has an expense ratio of 1.25-1.5%. The second category is front- or back-end loads, which are sales commissions charged upon buying or selling the mutual fund. On the brighter side, there are no-load mutual funds available.

ETFs are significantly cheaper to own. Investors who buy ETFs do so through brokers, rather than buying directly from the fund. As a result, ETFs have lower sales and marketing fees, which translates into lower operating expenses that cut into returns. On the other hand, ETFs come with a trading cost. Unless they are a proprietary fund where the fee is waived, ETFs incur a brokerage commission.

Relatedly, the cost of buying in can be a deterrent for mutual funds. ETFs are more accessible to investors as they don’t have minimums, whereas mutual fund minimums can range from $5,000-$50,000.

Investment Strategy
Mutual funds are run by professional money managers who do the research to make the buying and selling decisions within the fund. The goal of this active management is to beat the market. For some investors, the allure of outperforming the market justifies the higher cost of owning the fund.

ETFs are overseen by professional money managers who try to match the ETF’s performance to its benchmark index and minimize capital gain distributions. The goal of this passive management is to track the market and not risk underperformance. For some investors, the perceived safety of a passive strategy is more desirable than the heightened uncertainty of an active strategy.

Pick Your Own
Overall, mutual funds offer an active management strategy designed to beat the market, at a relatively high cost, whereas ETFs offer a passive management strategy designed to track the market, at a relatively low cost. Mutual funds have more trading limitations than ETFs, but there are more mutual funds to choose from than ETFs. Many people want to know, which fund type is better? Not surprisingly, it depends on the investor’s financial situation.

For investors who manage their own portfolios, mutual funds could be preferable for those with a longer time horizon and little interest in trading, and ETFs could be preferable for those with a shorter time horizon and interest in more frequent trading. When considering taxes, ETFs could be better for investors who are sensitive to taxes. When considering performance, ETFs could be less compromised by fees, but mutual funds could have higher returns. And for investors who use investment managers to manage their portfolios, it is important to take a meta view with either fund type, as the success of the investment strategy is presumably the key determinant.

Just Say No to Variable Annuities

Variable annuities are private financial contracts that provide income for a specified period of time, such a number of years or for life, and are tied to the investment performance of the mutual funds held in the contract. While the promise of a fixed income stream is enticing, I’ll level with you about the many downsides. In short, variable annuities are expensive, restrictive, and unnecessarily complicated financial products that offset any financial benefits they claim to offer.

Caveat emptor (“Buyer beware”). The salesperson pushing a variable annuity is largely motivated by the high commissions they will receive from selling it. I belong in the camp where if you are a financial professional, your fiduciary duty is implicit and paramount, and the client’s best interests always come first. The financial professional should never be incentivized to undermine the client’s best interests for their own gain. However, in the case of variable annuities, there couldn’t be a more egregious conflict of interest.

Here is a plethora of reasons not to buy one:

Commissions. Annuities are primarily front-end loaded, commission-based products. When a salesperson tries to sell you an annuity, don’t be afraid to ask about the commission they collect by selling it to you. Annuity firms can pay out commissions of 5% or more. Reality check: for each $100,000 you plunk into the annuity, that’s $5,000 or more in commissions. Furthermore, the mutual funds held in the annuity charge commission-like fees in the form of front-end loads, back-end loads, and 12b-1 fees.

Surrender charges. Most annuity firms charge a hefty surrender fee, usually on a seven year scale. For example, a $100,000 investment could cost you $8,000, or 8%, in surrender charges if you take your money out in the first year. The surrender charges usually go down 1% per year until reaching 0% at the end of the surrender period.

Fees. Additionally, there is a raft of dubious fees that may be charged by the annuity firm. This can include, but is not limited to, any of the following: asset fees, management fees, annual fees, quarterly transaction fees, withdrawal fees, rider fees, administrative fees, mortality and expense fees. With fees in aggregate costing between 2-4% annually, it’s difficult for investors to make money. At best, stated interest rate contracts (often called “guaranteed” interest rate contracts) may end up only paying out the stated rate (like 2%) because the rest is negated by fees. At worst, the fees negate any profits whatsoever.

Risk. The value of a variable annuity goes up and down with the market, so growth is not assured. Consider what would happen if the annuitant were to die prematurely. If the annuity has not been annuitized, the beneficiaries receive the value of the account. Depending on investment performance, this could be significantly less than what was originally invested. Or, if the annuity has been annuitized, all payments cease, even if only one payment has been made.

Irreversible consequences. Once you annuitize, you give up the ability to recover your lump sum or pass it on to beneficiaries. For example, if you put $250,000 into an annuity at age 60 and agree to receive a monthly income for the rest of your life, it could take 25 years to break even. It’s worth belaboring my last point as well – all payments cease at the death of the annuitant.

Poor tax planning. Once you put after-tax dollars into an annuity contract, withdrawals are taxed as ordinary income rather than at more favorable long-term capital gains rates.

Inflation. Rates are currently at historic lows, and will increase in the future. Over time, the purchasing power of fixed annuity payments is greatly reduced by inflation.

No socially responsible choices. Most annuities do not have any environmental, social, or governance screens that measure sustainability and ethics in regard to investments. As such, your investments may be supporting companies not aligned with your values.

Intentional derangement. Annuity contracts seem to be complex on purpose and the salespeople who tout them seem to skimp on disclosure. If the annuitant doesn’t fully grasp the terms of the contract, this benefits the salesperson, who likely doesn’t fully understand it either. Numerous clients have come to me with annuity contracts from other financial professionals and they can’t make heads or tails of them, and they certainly aren’t aware of all the limitations. Older retirees in particular are vulnerable to this dishonorable practice.

These myriad pitfalls of variable annuities add up to a vehement Do Not Touch With A Ten-Foot Pole rating.

Roth IRAs: The Best Thing Since Sliced Bread?

The Roth IRA is a fantastic investment vehicle that many people should consider as part of their overall retirement plan. Why? Here are 9 good reasons to open a Roth IRA:

  • Earnings will be tax-free if certain conditions are met.
    Roth IRAs have the same benefits of tax-free growth as Traditional IRAs.
  • Withdrawals will be tax-free if certain conditions are met.
    Roth IRA contributions come from after-tax money. This means you’ve already paid the taxes on this money before you make your contribution, and this is why there is no tax deduction for your contribution (unlike a Traditional IRA contribution). However, there is a tremendous benefit you receive from paying the taxes on the front end – you don’t have to pay taxes on the back end when you make withdrawals.
  • Lock in today’s tax rates.
    If tax rates increase in the future (highly likely based on historical data), or if your tax rate in retirement will be higher than your tax rate now, a Roth IRA could be a banner idea. Investors who expect to have a higher tax rate in retirement have the most to gain with a Roth IRA, because you pay lower taxes on contributions now to avoid higher taxes on withdrawals later. This is particularly true for younger investors, for the younger you are, the more earning potential you have, and the more chance your income will be higher at retirement. Put another way, the greater the difference between your income now and your income in retirement, the more advantageous a Roth IRA can be.
  • No Required Minimum Distributions.
    After age 70½, Traditional IRA account owners are required to take annual distributions from their account and pay the resulting income tax each year. It can be undesirable to take money out of an investment account if it is not immediately needed, and pay income tax on it. Additionally, the penalty for failing to withdraw the correct amount is a whopping 50 percent of the amount that should have been withdrawn in addition to the income tax due. On the other hand, Roth IRA account owners are not required to take annual distributions, which gives them more flexibility to time withdrawals with needs, achieve growth, and pass on tax-free money to their heirs.
  • No age requirement for contributions.
    No matter how old you are, as long as you have earned income, you can contribute to a Roth IRA. With Traditional IRAs, you can’t contribute if you are older than age 70½.
  • Offers flexibility.
    A Roth IRA enables you to take out 100% of what you have contributed at any time and for any reason, with no taxes or penalties.
  • Offers tax diversification in retirement.
    Roth IRAs can help you better manage your tax liability in retirement. For example, you can take distributions from your Traditional IRA up to the limit of your tax bracket, and then take the rest from your Roth IRA, without jumping up a tax bracket.
  • Benefits your heirs.
    Since Roth IRAs don’t have required minimum distributions, they can increase significantly in value over the years for your heirs. With Traditional IRAs, beneficiaries must pay taxes on the money they withdraw. However, with Roth IRAs, beneficiaries can receive tax-free distributions of the money left to them.
  • Open to everyone.
    There are income limits for Roth IRA contributions but investors who exceed these limits may still be able to contribute to one by converting money from other retirement accounts.

Please consult your financial advisor to assess if a Roth IRA is right for you.